INTERMEDIATE SANCTIONS FOR "EXCESS BENEFIT TRANSACTIONS"

By Martin E. Greif, CPA, Goldstein Golub Kessler & Co., P.C.

Federal intermediate tax sanctions became law on July 30, 1996, when President Clinton signed the Taxpayer Bill of Rights 2.

This legislation is likely to change the manner in which many tax-exempt organizations approach business transactions with corporate "insiders."

Penalty excise taxes may now be imposed as an intermediate sanction when an IRC section 501(c)(3) or 501(c)(4) organization engages in an "excess benefit transaction." In such an event, these excise taxes are imposed on "disqualified persons" receiving the excess benefit and on organization managers who knowingly participate in the transactions. The penalty is imposed upon the participating individuals, but not upon the exempt organization itself. Private foundations are not subject to these sanctions but remain subject to their existing regime under current law.

The committee report indicates that intermediate sanctions for excess benefit transactions are expected to be the sole sanction imposed, unless the excess benefit is significant enough to question whether the organization functions as a tax-exempt organization. Accordingly, revocation of the organization's tax-exempt status, with or without accompanying excise taxes, is not a consideration except in the most extreme cases.

Excess Benefit Transaction

An "excess benefit transaction" is any transaction in which an economic benefit is provided directly or indirectly to a "disqualified person" and that benefit exceeds the value of the consideration (including performance of services) received by the organization. This would include the following types of transactions and financial arrangements: a) A "disqualified person" (i.e., an insider) engages in a nonfair-market-value transaction directly or indirectly with the tax-exempt organization; b) A "disqualified person" receives unreasonable compensation from the tax-exempt organization; or c) To the extent provided in Treasury Department regulations, a "disqualified person" receives payment based on the income of the organization in an arrangement that violates the private inurement prohibition.

The IRS will apply existing tax law standards in determining reasonableness of compensation and fair market value. In determining whether compensation is reasonable, the committee report suggests that the parties to a transaction can rely on a rebuttable presumption of reasonableness for a compensation package that was approved by an independent board or committee--

1) composed of persons unrelated to and not controlled by the disqualified persons,

2) that relied on appropriate comparability data, and

3) that adequately documented the basis for its determination.

A rebuttable presumption would also result as to the reasonableness of the valuation of property transferred between an organization and a disqualified person if the transfer is approved by an independent board that uses appropriate comparability data.

Therefore, if these three criteria are met, compensation arrangements, for example, will have the benefit of a rebuttable presumption of reasonableness. Accordingly, intermediate sanctions cannot be imposed unless the IRS demonstrates sufficient contrary evidence to rebut the presumption.

Therefore, where appropriate, all compensation arrangements and decisions, as well as "insider transactions," should be approved in advance by an independent board or committee, using the best available relevant comparability data, and the boards should thoroughly document the basis for their determination.

Disqualified Person

An individual designated as an officer, director, or trustee does not automatically have the status of a disqualified person.

The definition of a "disqualified person" focuses on individuals who are in a position to exercise "substantial influence" over the affairs of the organization, whether by virtue of being an organizational manager or otherwise. "Disqualified persons" also include a) certain family members, b) corporations, partnerships, trusts, or estates in which disqualified persons control more than 35 percent of the interest, and c) any person who was a disqualified person at any time during the previous five-year period ending on the date of the transaction.

Penalties

The penalty excise tax follows a two-tier format. A disqualified person who benefits from an excess benefit transaction is subject to a first-tier penalty tax equal to 25% of the amount of the excess benefit. Organization managers who participate in an excess benefit transaction knowing that it is improper are subject to a first-tier penalty tax of 10% of the amount of the excess benefit (to a maximum of $10,000). Second-tier taxes
of 200% of the amount of the excess benefit may be imposed on a disqualified person if there is no correction of the excess benefit in a timely manner. For this purpose, "correction" means undoing the excess benefit to the extent
possible, establishing safeguards against future violations, and taking additional action prescribed by Treasury
regulations.

Effective Date

It is important to note that the effective date of these provisions is retroactive to excess benefit transactions occurring on or after September 14, 1995.

The act will not apply to any benefit arising out of a transaction pursuant to a written contract which was binding on September 13, 1995, and all times thereafter. However, to qualify, the contract must have been binding before the excess benefit arose. Also, continued coverage under the binding contract rule is available only if no material terms of the contract are subsequently changed.

In addition to a retroactive effective date, the committee report provides for a "retroactive documentation period." Transactions entered into after September 13, 1995, and before January 1, 1997, may rely on the rebuttable presumption of reasonableness if, within 90 days after entering into the transaction, the parties satisfy the basic requirements for the presumption. After December 31, 1996, the presumption will apply only if the requirements were met before payment of the excess benefit (or, to the extent provided by Treasury regulations, within a reasonable period thereafter). Therefore, organizations concerned as to whether transactions occurring during this period have the potential to be characterized as excess benefit transactions are urged to document valuation determinations and their decision-making
process.

Additional Disclosure Requirements

The act provides for increased Form 990 disclosure requirements. Under the conference agreement, tax-exempt organizations are required to disclose on Form 990, the name of each individual who was in a position to exercise substantial influence over the affairs of the organization. Subsequent revisions of Form 990 will request expanded information reporting, such as whether there are any economic transactions between disqualified persons and the reporting entity, as well as other information required by the IRS with respect to disqualified persons [IRC section 6033(b) (10)­(14)]. *

WHAT COSTS MORE: FOOD OR TAXES?

The Tax Foundation recently reported that the average household now pays more in Federal, state, and local taxes than they pay on food, clothing, and household costs. And the study excluded sales taxes.

The average household's combined tax burden is $21,365 and their cost of food, clothing, and household costs is $19,292. Lower income households, at least those with less than $22,500, pay less on these necessities than on taxes (not counting sales tax). *

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editors:
Richard M. Barth. CPA

Daniel O'Connell, CPA
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